1 ================================================================================ SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 --------------- FORM 10-Q --------------- (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JANUARY 28, 2000 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ____________ TO ____________ . COMMISSION FILE NUMBER 0-27130 NETWORK APPLIANCE, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) CALIFORNIA 77-0307520 (STATE OR OTHER JURISDICTION OF (IRS EMPLOYER IDENTIFICATION NO.) INCORPORATION OR ORGANIZATION) 495 EAST JAVA DRIVE, SUNNYVALE, CALIFORNIA 94089 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (408) 822-6000 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Number of shares outstanding of the registrant's class of common stock, as of the latest practicable date. <TABLE> <CAPTION> OUTSTANDING AT CLASS JANUARY 28, 2000 ----- ---------------- <S> <C> Common Stock............. 152,284,841 </TABLE> ================================================================================
2 TABLE OF CONTENTS <TABLE> <CAPTION> PAGE NO. -------- <S> <C> PART I -- FINANCIAL INFORMATION Item 1. Condensed Consolidated Financial Statements (Unaudited) Condensed Consolidated Balance Sheets as of January 28, 2000 and April 30, 1999 2 Condensed Consolidated Statements of Income for the three and nine-month periods ended January 28, 2000 and January 29, 1999 3 Condensed Consolidated Statements of Cash Flows for the nine-month periods ended January 28, 2000 and January 29, 1999 4 Notes to Condensed Consolidated Financial Statements 5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 8 Item 3. Quantitative and Qualitative Disclosures About Market Risk 13 PART II--OTHER INFORMATION Item 1. Legal Proceedings 14 Item 2. Changes in Securities 14 Item 3. Defaults Upon Senior Securities 14 Item 4. Submission of Matters to Vote of Securityholders 14 Item 5. Other Information 14 Item 6. Exhibits and Reports on Form 8-K 15 SIGNATURE 16 </TABLE> 1
3 PART I. FINANCIAL INFORMATION ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS NETWORK APPLIANCE, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) <TABLE> <CAPTION> JANUARY 28, APRIL 30, 2000 1999 ----------- --------- (UNAUDITED) ** <S> <C> <C> ASSETS CURRENT ASSETS: Cash and cash equivalents $ 231,416 $ 221,284 Short-term investments 58,636 5,800 Accounts receivable, net 99,674 57,163 Inventories 20,878 13,581 Prepaid expenses and other assets 9,653 7,384 Deferred taxes 27,171 10,134 --------- --------- Total current assets 447,428 315,346 PROPERTY AND EQUIPMENT, NET 33,646 19,271 DEPOSITS 7,170 7,000 OTHER ASSETS 5,672 4,730 --------- --------- $ 493,916 $ 346,347 ========= ========= LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 21,991 $ 15,126 Income taxes payable 4,195 1,108 Accrued compensation and related benefits 24,328 15,189 Other accrued liabilities 8,769 7,633 Deferred revenue 18,465 11,474 --------- --------- Total current liabilities 77,748 50,530 LONG-TERM OBLIGATIONS 55 93 --------- --------- 77,803 50,623 --------- --------- SHAREHOLDERS' EQUITY: Common stock 312,144 240,093 Retained earnings 105,268 55,954 Cumulative other comprehensive loss (1,299) (323) --------- --------- Total shareholders' equity 416,113 295,724 --------- --------- $ 493,916 $ 346,347 ========= ========= </TABLE> ** Derived from audited consolidated financial statements. See accompanying notes to condensed consolidated financial statements. 2
4 NETWORK APPLIANCE, INC. CONDENSED CONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED) <TABLE> <CAPTION> THREE MONTHS ENDED NINE MONTHS ENDED -------------------------- --------------------------- JANUARY 28, JANUARY 29, JANUARY 28, JANUARY 29, 2000 1999 2000 1999 ----------- ----------- ----------- ----------- <S> <C> <C> <C> <C> NET SALES $ 151,290 $ 75,616 $ 379,281 $ 198,616 COST OF SALES 61,415 30,818 155,471 80,938 --------- --------- --------- --------- Gross Margin 89,875 44,798 223,810 117,678 --------- --------- --------- --------- OPERATING EXPENSES: Sales and marketing 40,194 19,831 99,626 51,830 Research and development 16,424 7,815 41,106 20,618 General and administrative 5,470 2,655 13,775 7,092 --------- --------- --------- --------- Total operating expenses 62,088 30,301 154,507 79,540 --------- --------- --------- --------- INCOME FROM OPERATIONS 27,787 14,497 69,303 38,138 --------- --------- --------- --------- OTHER INCOME (EXPENSE): Interest Income 2,860 626 7,503 1,634 Other income (expense), net 49 (84) (350) 24 --------- --------- --------- --------- Total other income, net 2,909 542 7,153 1,658 --------- --------- --------- --------- INCOME BEFORE INCOME TAXES 30,696 15,039 76,456 39,796 PROVISION FOR INCOME TAXES 10,897 5,645 27,142 14,929 --------- --------- --------- --------- NET INCOME $ 19,799 $ 9,394 $ 49,314 $ 24,867 ========= ========= ========= ========= NET INCOME PER SHARE (1): Basic $ 0.13 $ 0.07 $ 0.33 $ 0.18 ========= ========= ========= ========= Diluted $ 0.11 $ 0.06 $ 0.29 $ 0.16 ========= ========= ========= ========= Pro Forma - Basic (Note 8) $ 0.07 $ 0.03 $ 0.17 $ 0.09 ========= ========= ========= ========= Pro Forma - Diluted (Note 8) $ 0.06 $ 0.03 $ 0.14 $ 0.08 ========= ========= ========= ========= SHARES USED IN PER SHARE CALCULATIONS (1): Basic 150,461 137,476 148,294 135,606 ========= ========= ========= ========= Diluted 175,168 157,864 170,316 153,358 ========= ========= ========= ========= Pro Forma - Basic (Note 8) 300,922 274,952 296,588 271,212 ========= ========= ========= ========= Pro Forma - Diluted (Note 8) 350,336 315,728 340,632 306,716 ========= ========= ========= ========= </TABLE> (1) Share and per share amounts have been adjusted to reflect the two-for-one stock split which was effective December 20, 1999. See accompanying notes to condensed consolidated financial statements. 3
5 NETWORK APPLIANCE, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED) <TABLE> <CAPTION> NINE MONTHS ENDED --------------------------- JANUARY 28, JANUARY 29, 2000 1999 ----------- ----------- <S> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 49,314 $ 24,867 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 10,732 7,091 Provision for doubtful accounts 996 873 Deferred income taxes (17,037) (4,683) Deferred rent (38) (47) Changes in assets and liabilities: Accounts receivable (43,667) (17,397) Inventories (9,623) (3,065) Prepaid expenses and other assets (3,379) (1,069) Accounts payable 6,865 (1,745) Income taxes payable 41,287 11,812 Accrued compensation and related benefits 9,139 3,187 Other accrued liabilities 1,136 3,385 Deferred revenue 6,991 3,279 --------- --------- Net cash provided by operating activities 52,716 26,488 --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of short-term investments (62,636) (15,230) Redemptions of short-term investments 9,650 17,880 Purchases of property and equipment (22,472) (11,615) Payment/refund of deposits, net (170) (7,000) --------- --------- Net cash used in investing activities (75,628) (15,965) --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from sale of common stock, net 33,044 12,048 --------- --------- Net cash provided by financing activities 33,044 12,048 --------- --------- NET INCREASE IN CASH AND CASH EQUIVALENTS 10,132 22,571 CASH AND CASH EQUIVALENTS: Beginning of period 221,284 37,315 --------- --------- End of period $ 231,416 $ 59,886 ========= ========= NONCASH INVESTING AND FINANCING ACTIVITIES: Income tax benefit from employee stock transactions $ 38,200 $ 12,210 SUPPLEMENTAL CASH FLOW INFORMATION: Income taxes paid net of refund $ 1,517 $ 7,031 </TABLE> See accompanying notes to condensed consolidated financial statements. 4
6 NETWORK APPLIANCE, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS The accompanying condensed consolidated financial statements have been prepared by Network Appliance, Inc. without audit and reflect all adjustments, which are, in the opinion of management, necessary for a fair presentation of our financial position and results of operations for the interim periods. The statements have been prepared in accordance with the regulations of the Securities and Exchange Commission (SEC). Accordingly, they do not include all information and footnotes required by generally accepted accounting principles. The results of operations for the three and nine-month periods ended January 28, 2000 are not necessarily indicative of the operating results to be expected for the full fiscal year or future operating periods. The information included in this report should be read in conjunction with the audited consolidated financial statements and notes thereto for the fiscal year ended April 30, 1999 and the risk factors as set forth in our Annual Report on Form 10-K, including, without limitation, risks relating to fluctuating operating results, customer and market acceptance of new products, dependence on new products, rapid technological change, litigation, dependence on growth in the network file server market, expansion of international operations, product concentration, changing product mix, competition, management of expanding operations, dependence on high-quality components, dependence on proprietary technology, intellectual property rights, dependence on key personnel, volatility of stock price, shares eligible for future sale, effect of certain anti-takeover provisions, dilution and the Year 2000 Issue. Any party interested in reviewing these publicly available documents should contact the SEC or our Chief Financial Officer. 2. SIGNIFICANT ACCOUNTING POLICIES Fiscal Periods - We operate on a 52-week or 53-week year ending on the last Friday in April. Fiscal 2000 is a 52-week year. Fiscal 1999 was a 53-week year. The quarter ended January 28, 2000 includes 13 weeks of operating activity, compared to 13 weeks of activity for the corresponding period of the prior fiscal year. The nine-months ended January 28, 2000 includes 39 weeks of activity, compared to 40 weeks of activity for the corresponding period of the prior fiscal year. Foreign Currency Translation - In the first quarter of fiscal 2000, we determined that the functional currencies of certain of our foreign subsidiaries had changed from the local currencies to the Euro. Accordingly, assets and liabilities of such foreign subsidiaries are translated into the Euro at the exchange rates in effect as of the balance sheet date, and results of operations for each subsidiary are translated using average rates in effect for the period presented. Translation adjustments have been included within shareholders' equity as a cumulative other comprehensive loss. The effect of the change in functional currencies did not have a material impact on our consolidated financial position, results of operations or cash flows. 5
7 NETWORK APPLIANCE, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 3. INVENTORIES Inventories consist of the following: <TABLE> <CAPTION> JANUARY 28, APRIL 30, 2000 1999 ----------- --------- (IN THOUSANDS) <S> <C> <C> Purchased components $ 7,741 $ 5,316 Work in process 4,253 1,727 Finished goods 8,884 6,538 ------- ------- $20,878 $13,581 ======= ======= </TABLE> 4. NET INCOME PER SHARE The following is a reconciliation of the numerators and denominators of the basic and diluted net income per share computations for the periods presented: <TABLE> <CAPTION> THREE MONTHS ENDED NINE MONTHS ENDED ------------------------------- ------------------------------- JANUARY 28, JANUARY 29, JANUARY 28, JANUARY 29, 2000 1999 2000 1999 ------------ ------------ ------------ ------------ (In thousands, except per share amounts) <S> <C> <C> <C> <C> NET INCOME (NUMERATOR): Net income, basic and diluted $ 19,799 $ 9,394 $ 49,314 $ 24,867 ============ ============ ============ ============ SHARES (DENOMINATOR): Weighted average common shares outstanding 150,536 137,624 148,395 136,288 Weighted average common shares outstanding subject to repurchase (75) (148) (101) (682) ------------ ------------ ------------ ------------ Shares used in basic computation 150,461 137,476 148,294 135,606 Weighted average common shares outstanding subject to repurchase 75 148 101 682 Common shares issuable upon exercise of stock options 24,632 20,240 21,921 17,070 ------------ ------------ ------------ ------------ Shares used in diluted computation 175,168 157,864 170,316 153,358 ============ ============ ============ ============ NET INCOME PER SHARE: Basic $ 0.13 $ 0.07 $ 0.33 $ 0.18 ============ ============ ============ ============ Diluted $ 0.11 $ 0.06 $ 0.29 $ 0.16 ============ ============ ============ ============ </TABLE> 6
8 NETWORK APPLIANCE, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 5. COMPREHENSIVE INCOME The components of comprehensive income, net of tax, are as follows: <TABLE> <CAPTION> THREE MONTHS ENDED NINE MONTHS ENDED ------------------------------- ------------------------------- JANUARY 28, JANUARY 29, JANUARY 28, JANUARY 29, 2000 1999 2000 1999 ------------ ------------ ------------ ------------ <S> <C> <C> <C> <C> (IN THOUSANDS) Net income $ 19,799 $ 9,394 $ 49,314 $ 24,867 Change in cumulative translation adjustment (1,050) (105) (976) (123) ------------ ------------ ------------ ------------ Comprehensive income $ 18,749 $ 9,289 $ 48,338 $ 24,744 ============ ============ ============ ============ </TABLE> 6. NEW ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities," which defines derivatives, requires that all derivatives be carried at fair value, and provides for hedging accounting when certain conditions are met. This statement is effective for all fiscal quarters of fiscal years beginning after June 15, 2000. Although we have not fully assessed the implications of this new statement, we do not believe adoption of this statement will have a material impact on our consolidated financial position, results of operations or cash flows. 7. COMMITMENTS In fiscal 1999, we executed agreements to acquire approximately 18 acres of land in Sunnyvale, California and to develop 393,000 square feet of buildings. We subsequently assigned our rights and obligations under all the agreements for the Sunnyvale facilities to a third-party entity and entered into three operating leases. The leases require monthly payments, which vary, based on the London Interbank Offered Rate (LIBOR) plus a spread (7.5% at January 28, 2000). The aggregate annual minimum rent commitment under one lease, which began in August 1999, is approximately $3.3 million. The lease payments under the other two operating leases are expected to commence in June 2000 and will also vary based on LIBOR plus a spread. The operating leases mentioned above require us to maintain specified financial covenants with which we were in compliance as of January 28, 2000. We have commitments related to operating lease arrangements, under which we have an option to purchase the properties for an aggregate of $190.0 million, or arrange for the sale of the properties to a third party for at least the option price with a contingent liability for any deficiency. 8. SUBSEQUENT EVENTS On February 10, 2000, the Board of Directors approved a two-for-one stock split of the Company's common stock to be distributed on or about March 22, 2000 to holders of record on March 10, 2000. Pro forma share and per-share amounts have been presented within the Condensed Consolidated Statements of Income to reflect the stock split. 7
9 This Form 10-Q contains forward-looking statements about future results, which are subject to risks and uncertainties, including those discussed below. Our actual results may differ significantly from the results discussed in the forward-looking statements. We are subject to a variety of other additional risk factors, more fully described in our Annual Report on Form 10-K filed with the Securities and Exchange Commission. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS The following table sets forth certain consolidated statements of income data as a percentage of net sales for the periods indicated: <TABLE> <CAPTION> THREE MONTHS ENDED NINE MONTHS ENDED -------------------------- -------------------------- JANUARY 28, JANUARY 29, JANUARY 28, JANUARY 29, 2000 1999 2000 1999 ----------- ----------- ----------- ----------- <S> <C> <C> <C> <C> Net sales 100.0% 100.0% 100.0% 100.0% Cost of sales 40.6 40.8 41.0 40.8 ------ ------ ------ ------ Gross margin 59.4 59.2 59.0 59.2 ------ ------ ------ ------ Operating expenses: Sales and marketing 26.6 26.2 26.3 26.1 Research and development 10.8 10.3 10.8 10.4 General and administrative 3.6 3.5 3.6 3.5 ------ ------ ------ ------ Total operating expenses 41.0 40.0 40.7 40.0 ------ ------ ------ ------ Income from operations 18.4 19.2 18.3 19.2 Total other income, net 1.9 0.7 1.9 0.8 ------ ------ ------ ------ Income before income taxes 20.3 19.9 20.2 20.0 Provision for income taxes 7.2 7.5 7.2 7.5 ------ ------ ------ ------ Net income 13.1% 12.4% 13.0% 12.5% ====== ====== ====== ====== </TABLE> Net Sales -- Net sales increased by 100.1% to $151.3 million for the three-months ended January 28, 2000, from $75.6 million for the three-months ended January 29, 1999. Net sales increased by 91.0% to $379.3 million for the nine-months ended January 28, 2000, from $198.6 million for the nine-months ended January 29, 1999. Net sales growth was across all geographies, products and markets. This increase in net sales for both the three and nine-months ended January 28, 2000 was primarily attributable to a higher volume of units shipped, as compared to the corresponding periods of the prior fiscal year. Factors impacting unit growth include: - growth in the network attached storage market and increased market acceptance of the appliance concept; - acceleration in deployment of our products among Internet and enterprise related customers, particularly for E-business and database applications; - strong demand for our F700 filer product family utilizing primarily fibre-channel connectivity; - increased worldwide demand for our NetCache(TM) solutions; - increased worldwide shipment of NetApp(R) Cluster Failover solutions, which require another filer to take over in the event of a hardware failure; - increased demand for the SnapMirror(TM) software option, which requires multiple filers to provide remote mirroring of data for quick disaster recovery and backup at remote sites; - expansion of our direct sales force; and - sales to our two OEM partners. 8
10 Net sales growth was also positively impacted by: - a higher average selling price due to the introduction of new software features: SnapMirror, SnapRestore(TM) and Cluster Failover, supporting mission-critical applications; - the increase in storage capacity; - increased add-on software revenue from multi-protocol solutions; and - higher software subscription and service revenues to support a growing installed base. Overall net sales growth was partially offset by declining unit sales of our older product family and declining average selling price of the caching product family due primarily to competitive pricing pressure. International net sales (including United States exports) grew by 50.0% and 79.9% for the three and nine-month periods ended January 28, 2000, as compared to the comparable period of the prior fiscal year. International net sales were $46.9 million, or 31.0% of total net sales, and $109.6 million, or 28.9% of total net sales, for the three and nine-month periods ended January 28, 2000, respectively. The increase in international sales for the three and nine-month periods ended January 28, 2000, was primarily a result of European sales growth, due to increased headcount in the direct sales force, increased indirect channel sales, increased shipments of filers, Cluster Failover solutions, NetCache appliances and increased sales of add-on software licenses. Asia Pacific net sales growth for the three and nine-month periods ended January 28, 2000, was also primarily driven by increased sales through resellers, increased headcount in the direct sales force, increased shipments of filers, NetCache appliances and increased sales of add-on software licenses, as compared to the corresponding periods of the prior fiscal year. We cannot assure you that our net sales will continue to increase in absolute dollars or at the rate at which they have grown in recent fiscal periods. Gross Margin -- Gross margin increased slightly to 59.4% for the three-months ended January 28, 2000 from 59.2% for the three-months ended January 29, 1999. Gross margin decreased to 59.0% for the nine-months ended January 28, 2000 from 59.2% for the nine-months ended January 29, 1999. Gross margin was favorably impacted by: - increased licensing of add-on software products such as: multi-protocol, Cluster Failover, SnapMirror and SnapRestore associated with new filers shipped; - growth in software subscription due primarily to a larger installed base; - increased manufacturing efficiencies; - the increase in product volume; and - lower costs of key components. Gross margin was negatively impacted by sales price reductions on storage products due to competitive pricing pressure from other storage vendors and increased investments in customer service personnel in areas such as logistics and professional services. Our gross margin has been and will continue to be affected by a variety of factors, including: - competition; - product configuration; - direct versus indirect sales; - the mix and average selling prices of products, including software licenses; - new product introductions and enhancements; and - the cost of components and manufacturing labor. Sales and Marketing -- Sales and marketing expenses consist primarily of salaries, commissions, advertising and promotional expenses and certain customer service and support costs. Sales and marketing 9
11 expenses increased 102.7% to $40.2 million for the three-months ended January 28, 2000 from $19.8 million for the three-months ended January 29, 1999. Sales and marketing expenses increased 92.2% to $99.6 million for the nine-months ended January 28, 2000 from $51.8 million for the nine-months ended January 29, 1999. These expenses were 26.6% and 26.2% of net sales for the three-months ended January 28, 2000 and January 29, 1999, respectively, and were 26.3% and 26.1%, respectively, of net sales for the nine-month periods then ended. The increase in absolute dollars was primarily related to the continued worldwide expansion and increased headcount growth of our sales and customer service organizations, and increased commission expenses. During the quarter ended January 28, 2000, we launched an advertising campaign, which also contributed to absolute dollar increases in sales and marketing expenses. We expect to continue to increase our sales and marketing expenses in an effort to expand domestic and international markets, introduce new products, establish and expand new distribution channels and increase product and company awareness. We believe that our continued growth and profitability is dependent in part on the successful expansion of our international operations, and therefore, have committed significant resources to increase international sales. Research and Development -- Research and development expenses consist primarily of salaries and benefits, prototype expenses, non-recurring engineering charges and fees paid to outside consultants. Research and development expenses increased 110.2% to $16.4 million for the three-months ended January 28, 2000 from $7.8 million for the three-months ended January 29, 1999. These expenses represented 10.8% and 10.3% of net sales, respectively, for the three-months ended January 28, 2000 and January 29, 1999. For the nine-month periods, research and development expenses increased 99.4% to $41.1 million in fiscal 2000 from $20.6 million in fiscal 1999, and represented 10.8% and 10.4% of net sales, respectively, for those periods. Research and development expenses increased in absolute dollars, primarily as a result of increased headcount, ongoing support of current and future product development and enhancement efforts, prototyping expenses and non-recurring engineering charges associated with the development of new products and technologies. These new products included the F700 series filers, the Cluster Failover solutions, the C700 family, new enterprise software offerings and data management tools with SnapMirror, SnapRestore, SnapManager(TM) for Microsoft(R) Exchange and SecureAdmin(TM). New caching product introductions included Netcache software release 4.0 and Netcache 4.1, a streaming media appliance for Apple(R) Quicktime(TM), Microsoft(R) Windows Media(TM) and RealNetworks(R) Real System(TM) G2 users, delivering live broadcasting on the Internet. We believe that our future performance will depend in large part on our ability to maintain and enhance our current product line, develop new products that achieve market acceptance, maintain technological competitiveness and meet an expanding range of customer requirements. We intend to continuously expand our existing product offerings and introduce new products and expect that such expenditures will continue to increase in absolute dollars. For the three and nine-months ended January 28, 2000 and January 29, 1999, no software development costs were capitalized. General and Administrative -- General and administrative expenses increased 106.1% to $5.5 million for the three-months ended January 28, 2000, from $2.7 million for the three-months ended January 29, 1999. These expenses represented 3.6% and 3.5% of net sales for the three-months ended for such periods. For the nine-month periods, general and administrative expenses increased 94.2% to $13.8 million in fiscal 2000 from $7.1 million in fiscal 1999 and represented 3.6% and 3.5% of net sales for the nine-months ended for such periods. Increases in absolute dollars were primarily due to increased headcount, expenses associated with initiatives to implement enterprise-wide management information systems, increases in professional services, consulting fees and outside service fees. We believe that our general and administrative expenses will increase in absolute dollars as we continue to build our infrastructure. Total Other Income, net -- Total other income, net, was $2.9 million and $0.5 million for the three-months ended January 28, 2000 and January 29, 1999, respectively. During the nine-months ended January 28, 2000, total other income, net, was $7.2 million, as compared to $1.7 million in the corresponding period of the prior year. The increase was due primarily to interest income earned on the net proceeds from the March 1999 follow-on public offering, cash generated from operations, and net proceeds from stock option exercises. The nine months of fiscal 1999 included gains from foreign currency transactions as compared to the nine months of fiscal 2000, where gains or losses from foreign transactions have been largely mitigated primarily through our hedging program. 10
12 Provision for Income Taxes -- Our effective tax rate was 35.5% for the three and nine-month periods ended January 28, 2000 compared to 37.5% for the three and nine-month periods ended January 29, 1999. The effective tax rates differed from the U.S. statutory rate of 35% primarily due to state taxes partially offset by earnings of foreign subsidiaries being taxed at lower rates. CERTAIN RISK FACTORS Although we have experienced significant revenue growth in recent periods, this growth may not be indicative of our future operating results. As a result, we believe that period-to-period comparisons of our results of operation are not necessarily meaningful and should not be relied upon as indicators of future performance. Many of the factors that could cause our quarterly operating results to fluctuate significantly in the future are beyond our control and include the following: - the level of competition in our target product markets; - the size, timing, and cancellation of significant orders; - product configuration and mix; - market acceptance of new products and product enhancements; - new product announcements or introductions by us or our competitors; - deferrals of customer orders in anticipation of new products or product enhancements; - changes in pricing by us or our competitors; - our ability to timely develop, introduce and market new products and enhancements; - supply constraints; - technological changes in our target product markets; - the levels of expenditure on research and development and expansion of our sales and marketing programs; - seasonality; and - general economic trends. In addition, sales for any future quarter may vary and accordingly be inconsistent with our plans. We generally operate with limited order backlog because our products are typically shipped shortly after orders are received. As a result, product sales in any quarter are generally dependent on orders booked and shipped in that quarter. Product sales are difficult to forecast because the network file server market is rapidly evolving and our sales cycle varies substantially from customer to customer. We conduct business internationally. International sales (including U.S. exports) were approximately 31.0% and 28.9% of total net sales for the three and nine-months ended January 28, 2000, respectively. Accordingly, our future operating results could be materially adversely affected by a variety of factors, some of which are beyond our control, including regulatory, political or economic conditions in a specific country or region, trade protection measures and other regulatory requirements and government spending patterns. Our international sales are denominated in U.S. dollars and in foreign currencies. An increase in the value of the U.S. dollar relative to foreign currencies could make our products more expensive and, therefore, potentially less competitive in foreign markets. For international sales and expenditures denominated in foreign currencies, we are subject to risks associated with currency fluctuations. We hedge risks associated with foreign currency transactions in order to minimize the impact of changes in foreign currency exchange rates on earnings. We utilize forward contracts to hedge trade and intercompany receivables and payables. All hedge contracts are marked to market through earnings every period. Additional risks inherent in our international business activities generally include, among others, longer accounts receivable payment cycles, difficulties in managing international operations and potentially adverse tax consequences. We cannot assure you that such factors will not materially adversely affect our future international sales and, consequently, our operating results. 11
13 Although operating results have not been materially and adversely affected by seasonality in the past, because of the significant seasonal effects experienced within the industry, particularly in Europe, we cannot assure you that our future operating results will not be adversely affected by seasonality. We believe that continued growth and profitability will require successful expansion of our international operations and sales and therefore we have committed significant resources to such expansion. In order to successfully expand international sales in fiscal 2000 and subsequent periods, we must strengthen foreign operations, hire additional personnel and recruit additional international distributors and resellers. This will require significant management attention and financial resources and could materially adversely affect our operating results. To the extent that we are unable to effect these additions in a timely manner, our growth, if any, in international sales will be limited, and our operating results could be materially adversely affected. In addition, we cannot assure you that we will be able to maintain or increase international market demand for our products. LIQUIDITY AND CAPITAL RESOURCES As of January 28, 2000, as compared to the April 30, 1999 balances, our cash, cash equivalents and short-term investments increased by $63.0 million to $290.1 million. Working capital increased by $104.9 million to $369.7 million. We generated cash from operating activities totaling $52.7 million and $26.5 million for the nine-month periods ended January 28, 2000 and January 29, 1999, respectively. Net cash provided by operating activities for the nine-month period ended January 28, 2000 principally related to net income of $49.3 million, increases in accounts payable, income taxes payable, accrued compensation and related benefits, deferred revenue and other accrued liabilities, coupled with depreciation and amortization which are non-cash expenses, partially offset by increases in accounts receivable, inventories, prepaid expenses and other assets and deferred income taxes. We used $22.5 million and $11.6 million of cash during the nine-month periods ended January 28, 2000 and January 29, 1999, respectively, for capital expenditures. The increases were primarily attributed to upgrades of software and computer equipment purchases and furniture and fixtures for the Sunnyvale headquarters facility. We have used $53.0 million during the nine-month period ended January 28, 2000 and received net proceeds of $2.7 million during the nine-month period ended January 29, 1999, for net short-term investment redemptions. During the nine-month period of fiscal 2000, we received back our $2.5 million deposit in connection with the $36.0 million operating lease. In September 1999, we executed an agreement to acquire 9.9 acres of land in Sunnyvale, California and the accompanying 178,996 square foot building. Under terms of the agreement, we paid $2.7 million of the $23.4 million purchase price as a nonrefundable deposit. The agreement allows us to assign our rights and obligations to a third-party entity should we decide to enter into an operating lease. We intend to assign our rights and obligations to a third-party entity and enter into an operating lease provided we can obtain satisfactory leasing terms. Financing activities provided $33.0 million and $12.0 million during the nine-month periods ended January 28, 2000 and January 29, 1999, respectively. The increase in cash provided by financing activities for the nine-months ended January 28, 2000, compared to the corresponding period of the prior fiscal year, was due to an increased quantity of stock options exercised at a higher average exercise price and a greater number of employees participating in the employee stock purchase plan. In November 1999, we executed an agreement to acquire 27.8 acres of land in Sunnyvale, California and the accompanying 354,266 square feet of buildings. Under terms of the agreement, we paid $3.0 million of the $61.0 million purchase price as a nonrefundable deposit. In December 1999, we assigned our rights and obligations under the agreement to a third-party entity and in exchange received back our $3.0 million deposit in January 2000. We subsequently entered into a $62.0 million operating lease for this property. Our lease payments will vary based on LIBOR plus a spread. The lease is for five years and can be renewed for two five-year periods, subject to the approval of the third-party entity. At the expiration or termination of the lease, we have the option to either purchase the property for $62.0 million, or arrange for the sale of the property to a third party for at least $62.0 with a contingent liability for any 12
14 deficiency. If the property is not purchased or sold as described above, we will be obligated for an additional lease payment of approximately $51.5 million. The lease also requires us to maintain specified financial covenants with which we were in compliance as at January 28, 2000. Excluding the commitment related to the aforementioned 178,996 square foot property, which we intend to assign to third parties and account for as operating leases, we currently have no significant commitments other than commitments under operating leases. We believe that our existing liquidity and capital resources, including the available amounts under our $5.0 million line of credit, are sufficient to fund our operations for at least the next twelve months. YEAR 2000 The Year 2000 issue refers to computer programs which use two digits rather than four to define a given year and which therefore might read a date using "00" as the year 1900 rather than the year 2000. As a result, many companies' systems and software may need to be upgraded or replaced in order to function correctly after December 31, 1999. Over the past year, we have been testing our computer systems and applications to evaluate Year 2000 problems, executing remediation activities to fix non-compliant systems and monitoring and testing products and systems. To date, we have not experienced any problems complying with the Year 2000 issue and have not been informed of any failures of our products from customers or Year 2000 disruptions from third party vendors. NEW ACCOUNTING STANDARDS In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," which defines derivatives, requires that all derivatives be carried at fair value, and provides for hedging accounting when certain conditions are met. This statement is effective for all fiscal quarters of fiscal years beginning after June 15, 2000. Although we have not fully assessed the implications of this new statement, we do not believe adoption of this statement will have a material impact on our consolidated financial position, results of operations or cash flows. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to market risk related to fluctuations in interest rates and in foreign currency exchange rates. We use certain derivative financial instruments to manage these risks. We do not use derivative financial instruments for speculative or trading purposes. All financial instruments are used in accordance with management-approved policies. Market Interest Risk Short-term Investments - As of January 28, 2000, we had short-term investments of $58.6 million. These short-term investments consist of highly liquid investments with original maturities at the date of purchase between three and twelve months. These investments are subject to interest rate risk and will decrease in value if market interest rates increase. A hypothetical 10 percent increase in market interest rates from levels at January 28, 2000, would cause the fair value of these short-term investments to decline by an immaterial amount. Because we have the ability to hold these investments until maturity we would not expect any significant decline in value of our investments caused by market interest rate changes. Declines in interest rates over time will, however, reduce our interest income. Operating Lease Commitments - As of January 28, 2000, we have outstanding lease commitments to a third-party entity under operating lease agreements, which vary based on a monthly LIBOR rate plus a spread. However, a hypothetical 10 percent decrease in interest rates would not have a material impact on us. Increases in interest rates could, however, increase our rent expenses associated with future lease payments. We do not currently hedge against interest rate increases. However, our investment portfolio 13
15 offers a natural hedge against interest rate risk from our operating lease commitments in the event of a significant increase in the market interest rate. The hypothetical changes and assumptions discussed above will be different from what actually occurs in the future. Furthermore, such computations do not anticipate actions that may be taken by management, should the hypothetical market changes actually occur over time. As a result, the effect on actual earnings in the future will differ from those described above. Foreign Currency Exchange Rate Risk - We hedge risks associated with foreign currency transactions in order to minimize the impact of changes in foreign currency exchange rates on earnings. We utilize forward contracts to hedge against the short-term impact of foreign currency fluctuations on certain assets and liabilities denominated in foreign currencies. All hedge instruments are marked to market through earnings every period. We believe that these forward contracts do not subject us to undue risk due to foreign exchange movements because gains and losses on these contracts are offset by losses and gains on the underlying assets and liabilities. All contracts have a maturity of less than one year and we do not defer any gains and losses, as they are all accounted for through earnings every period. The following table provides information about our foreign exchange forward contracts outstanding on January 28, 2000, (in thousands): <TABLE> <CAPTION> BUY/ FOREIGN CONTRACT VALUE FAIR VALUE CURRENCY SELL CURRENCY AMOUNT USD IN USD - ------------------------------------------------------------------------------- <S> <C> <C> <C> <C> EUR Sell 10,400 10,685 10,290 EUR Buy 2,000 2,011 1,979 GBP Sell 6,500 10,223 10,638 CHF Sell 4,300 2,646 2,636 CHF Buy 1,000 614 613 </TABLE> PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS None ITEM 2. CHANGES IN SECURITIES None ITEM 3. DEFAULTS UPON SENIOR SECURITIES None ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None ITEM 5. OTHER INFORMATION None 14
16 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBITS <TABLE> <S> <C> 10.43 Industrial Lease Agreement, dated December 20, 1999 between TRW Inc. and the Company in connection with 1347 Crossman Avenue in Sunnyvale, California 10.44 Industrial Lease Agreement, dated December 20, 1999 between TRW Inc. and the Company in connection with 1350 Geneva Drive in Sunnyvale, California 10.45 Industrial Lease Agreement, dated December 20, 1999 between TRW Inc. and the Company in connection with 1345 Crossman Avenue in Sunnyvale, California 10.46 Industrial Lease Agreement, dated December 20, 1999 between TRW Inc. and the Company in connection with 1330 Geneva Drive in Sunnyvale, California 10.47 Assignment of Agreement of Sale, dated December 20, 1999, by and between BNP Leasing and the Company 10.48 Purchase and Sale Agreement, dated November 16, 1999, by and between TRW Inc. and ESL Incorporated and the Company 10.49 Closing Certificate (Phase IV) and Agreement, dated December 20, 1999, by and between BNP Leasing Corporation and the Company 10.50 Lease Agreement (Phase IV - Land), dated December 20, 1999, by and between BNP Leasing Corporation and the Company 10.51 Lease Agreement (Phase IV - Improvements ), dated December 20, 1999, by and between BNP Leasing Corporation and the Company 10.52 Purchase Agreement (Phase IV - Land), dated December 20, 1999, by and between BNP Leasing Corporation and the Company 10.53 Purchase Agreement (Phase IV - Improvements), dated December 20, 1999, by and between BNP Leasing Corporation and the Company 10.54 Pledge Agreement (Phase IV - Land), dated December 20, 1999, by and between BNP Leasing Corporation and the Company 10.55 Pledge Agreement (Phase IV - Improvements), dated December 20, 1999, by and between BNP Leasing Corporation and the Company 10.56 Participation Agreement (Phase IV), dated December 20, 1999, by and between BNP Leasing Corporation and Banque Nationale De Paris 27.1 Financial Data Schedule 27.2 Restated Financial Data Schedules 27.3 Restated Financial Data Schedules 27.4 Restated Financial Data Schedules 27.5 Restated Financial Data Schedules 27.6 Restated Financial Data Schedules </TABLE> (b) REPORTS ON FORM 8-K None 15
17 SIGNATURE Pursuant to the requirements of the Securities and Exchange Act of 1934, as amended, the registrant duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. NETWORK APPLIANCE, INC. (Registrant) /s/ JEFFRY R. ALLEN --------------------------------------------- Jeffry R. Allen Senior Vice President Finance and Operations, Chief Financial Officer and Secretary Date: February 29, 2000 16
18 EXHIBIT INDEX <TABLE> <CAPTION> EXHIBIT NUMBER DESCRIPTION <S> <C> 10.43 Industrial Lease Agreement, dated December 20, 1999 between TRW Inc. and the Company in connection with 1347 Crossman Avenue in Sunnyvale, California 10.44 Industrial Lease Agreement, dated December 20, 1999 between TRW Inc. and the Company in connection with 1350 Geneva Drive in Sunnyvale, California 10.45 Industrial Lease Agreement, dated December 20, 1999 between TRW Inc. and the Company in connection with 1345 Crossman Avenue in Sunnyvale, California 10.46 Industrial Lease Agreement, dated December 20, 1999 between TRW Inc. and the Company in connection with 1330 Geneva Drive in Sunnyvale, California 10.47 Assignment of Agreement of Sale, dated December 20, 1999, by and between BNP Leasing and the Company 10.48 Purchase and Sale Agreement, dated November 16, 1999, by and between TRW Inc. and ESL Incorporated and the Company 10.49 Closing Certificate (Phase IV) and Agreement, dated December 20, 1999, by and between BNP Leasing Corporation and the Company 10.50 Lease Agreement (Phase IV - Land), dated December 20, 1999, by and between BNP Leasing Corporation and the Company 10.51 Lease Agreement (Phase IV - Improvements ), dated December 20, 1999, by and between BNP Leasing Corporation and the Company 10.52 Purchase Agreement (Phase IV - Land), dated December 20, 1999, by and between BNP Leasing Corporation and the Company 10.53 Purchase Agreement (Phase IV - Improvements), dated December 20, 1999, by and between BNP Leasing Corporation and the Company 10.54 Pledge Agreement (Phase IV - Land), dated December 20, 1999, by and between BNP Leasing Corporation and the Company 10.55 Pledge Agreement (Phase IV - Improvements), dated December 20, 1999, by and between BNP Leasing Corporation and the Company 10.56 Participation Agreement (Phase IV), dated December 20, 1999, by and between BNP Leasing Corporation and Banque Nationale De Paris 27.1 Financial Data Schedule 27.2 Restated Financial Data Schedules 27.3 Restated Financial Data Schedules 27.4 Restated Financial Data Schedules 27.5 Restated Financial Data Schedules 27.6 Restated Financial Data Schedules </TABLE> 17